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Serica Energy plc (LON:SQZ) Is Employing Capital Very Effectively

·4 min read

Today we'll look at Serica Energy plc (LON:SQZ) and reflect on its potential as an investment. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.

How Do You Calculate Return On Capital Employed?

Analysts use this formula to calculate return on capital employed:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for Serica Energy:

0.20 = UK£73m ÷ (UK£477m - UK£109m) (Based on the trailing twelve months to June 2019.)

So, Serica Energy has an ROCE of 20%.

Check out our latest analysis for Serica Energy

Is Serica Energy's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Serica Energy's ROCE is meaningfully better than the 10% average in the Oil and Gas industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Putting aside its position relative to its industry for now, in absolute terms, Serica Energy's ROCE is currently very good.

In our analysis, Serica Energy's ROCE appears to be 20%, compared to 3 years ago, when its ROCE was 2.8%. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Serica Energy's past growth compares to other companies.

AIM:SQZ Past Revenue and Net Income, January 29th 2020
AIM:SQZ Past Revenue and Net Income, January 29th 2020

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is, after all, simply a snap shot of a single year. Remember that most companies like Serica Energy are cyclical businesses. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

What Are Current Liabilities, And How Do They Affect Serica Energy's ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Serica Energy has current liabilities of UK£109m and total assets of UK£477m. Therefore its current liabilities are equivalent to approximately 23% of its total assets. The fairly low level of current liabilities won't have much impact on the already great ROCE.

The Bottom Line On Serica Energy's ROCE

This is good to see, and with such a high ROCE, Serica Energy may be worth a closer look. Serica Energy looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.